[The following is an excerpt from Chapter 13 of Gene Callahan's book, Economics for Real People. Read it here or buy it at mises.org]
In the economies of most modern industrial nations, a central bank manages the nation’s money supply and attempts to control the level of interest rates, at least to some extent. (In the United States, that central bank is called the Federal Reserve. Since it is the most powerful and famous central bank in the world, we will focus our discussion on “the Fed.”) Various rationales have been put forward for central bank interference in the market: to supply sufficient currency and credit to “meet the needs of commerce,” to ensure a “stable value” for the currency, to “fight inflation,” to smooth out fluctuations in the economy, and so on.
In light of our discussion of money and credit so far, those reasons are suspicious. We have seen that prices can adjust to whatever amount of currency is in the economy. Certainly, the adjustment process takes time and has associated costs. Therefore, we’d prefer gradual to rapid change, giving us more time to adjust. The need to dig up gold from the ground in order to create money acted as a regulator on the growth of the money supply during the period of the gold standard. That regulator led to a century-long period of remarkably low volatility in prices. Being able to create new money almost at will, as central banks can, obviously makes it easier to create rapid changes in the money supply. The various hyperinflations that have occurred in the last century, under fiat money regimes, attest to that fact.
Similarly, we have every reason to believe that the best mechanism for matching the businesses’ perceived credit needs with the available savings is the interest rate market. What really matters to a business is that it can acquire the goods, the knowledge, and the services it needs to complete its plans during their progress toward producing consumer goods. The cash a business borrows is important only as a means to help acquire those factors of production. If the real factors are not available, because people have not saved a sufficient amount out of current and past production to bring them into existence, then neither increasing the amount of dollars in circulation nor artificially lowering the interest rate will magically bring them forth from the void.
And we have already covered the reason that the search for a stable currency is hopeless: valuation is an aspect of human action, and there are no constant numerical values in human action. Every freely chosen value implies the possibility of a change in valuation. And, far from fighting inflation, the Fed is the main cause of it.
In this chapter, we will examine the final reason listed above, “smoothing out fluctuations in the economy,” in some depth. Over the course of the chapter we will see that the central bank tends to be the creator, and not the dissipater, of economic fluctuations. When it is putting on the brakes and deflating a bubble, it was usually the one that inflated the bubble in the first place.
Out of Gas
Image that you are a bus driver, at the edge of a desert, about to take a busload of passengers across it. You have left all gas stations behind. Your destination is a town on the other side of the wasteland before you. You are faced with a trade-off: the faster you try to reach the town, the less the passengers can use the air-conditioning to alleviate the desert heat. Both higher speeds and higher air-conditioning settings will use up the gas more quickly. And since, in our luxurious bus, each passenger has his own temperature control for his seat, you, the driver, cannot control the total amount of air conditioning used on the trip.
In order to make your decision, you look at your fuel gauge and determine how much gas you have. You tell the passengers that they must now make a trade-off between comfort on the way and speed traveled, as the more air-conditioning they choose to use, the faster the bus will consume fuel. Then you collect statements from the passengers on what temperature they will keep their seat. You perform some calculations on mileage, speed, and fuel consumption, and pick the fastest speed at which you can travel, given the amount of gas you have and the passengers’ statements about their use of the air-conditioning.
The passengers had to decide whether to cross the desert in greater comfort but arrive later at their final destination, or in less comfort but with an earlier arrival. The science of economics has little to say about the combination that they picked, other than that it seemed preferable to them at that moment of choice.
However, also imagine that, before you began your calculations, someone had sneaked up to the bus and replaced the passengers’ real choices with a fake set that chose a higher temperature, in other words, one that makes it seem they will use less fuel than they really will. You will make your choice on travel speed as if the passengers will tolerate an average temperature of, say, 80 degrees, whereas in reality they will demand to have the bus cooled to an average of 70 degrees.
Obviously, your calculations will prove to be incorrect, and the trip will not come out as you had planned. The trip will begin with you driving as if you have more resources available than you really do. It will end with you phoning for help, when the sputtering of your engine reveals the deception.
I offer the above as a metaphor for the Austrian business cycle theory (ABCT), which explains why most modern economies tend to swing through boom times and recessions. You, the driver, represent the entrepreneurs. The gas is the sum of the resources available in the economy. The trip across the desert is some period of production. The passengers represent the consumers. Their choice on how much to use the air conditioning is analogous to how much consumers want to consume now at the expense of saving for the future (i.e., their time preference). The speed of the bus is the amount of investment spending the entrepreneurs will undertake. The ultimate destination is the satisfaction of as many of the consumers’ wishes as possible. And it is the central bank — for instance, the Federal Reserve — that has sneaked up and tampered with the consumers’ choices.
What the central bank tampers with is the market’s reading of the consumers’ average time preference, which is the rate of originary interest. Consumers’ time preferences tell us how much capital will become available through consumer saving, or, in our metaphor, through cutting back on the air-conditioning.
When the central bank artificially lowers the rate of interest — we hear on the news that the Fed has cut rates to “stimulate the economy” — entrepreneurs make their plans as if consumers were willing to delay consumption and save more than they really are. As the bus driver, you act as if the passengers are willing to endure the heat enough for you to drive 70 miles per hour. In reality, they will force the bus to consume gas so rapidly that you should have planned to drive only 55. Your attempt to cross the desert will fail, leaving you out of gas.
Of course, the real economy does not simply come to a halt. At some point in the trip, it becomes apparent that the bus is using fuel too rapidly. The Fed, expressing a concern about “overheating,” will raise rates. The entrepreneurs will slow way down so that the bus does not simply die — they lay off employees, cancel investment projects, and reduce spending in other ways. The economy, after the boom at the start of the trip, has fallen into a recession.[1]
Our metaphor also allows us to differentiate between a “soft landing,” a “hard landing,” and a full crash. The further the bus has gone before the discrepancy between the market interest rate and consumers’ real time preference is accounted for, the “harder” a landing the economy will undergo. If the entrepreneurs discover the error early (or the central bank cuts short the expansion quickly), the bus may only have to slow to 50 miles per hour to complete the trip. If the credit expansion is continued for a long time the bus may wind up having to coast down hills with the engine off — and we have a fullscale depression, or crash.
As we saw in earlier chapters, interest rates reflect consumers’ time preference because it is what borrowers must pay lenders, in order to persuade the lenders to delay their own consumption. If I have $100, I could spend it today on a nice dinner with my wife. Or, I could lend it out for a year, at the end of which I could spend it on a somewhat nicer dinner.
Exactly how much nicer a dinner I must expect to receive before I will lend the money is an expression of my preference for current consumption over future consumption. If I demand a rate of interest of at least 5%, that means that a $105 dinner next year is marginally more valuable to me than a $100 dinner this year. On the other hand, if my friend Rob demands 10-percent interest, he is demanding a $110 dinner. He values current consumption compared to future consumption more highly than I do.
The net result of all lenders and borrowers expressing their time preference by offering and bidding on loans is the market rate of interest. In any real interest-rate market, that rate will include, besides originary interest, added interest to account for inflation (or subtracted interest to account for deflation), as well as a risk premium to account for the chance that the venture or person that the money has been lent to will go belly-up.
The rate of interest tells entrepreneurs whether a particular investment is worth making or not. In an unhampered market, without inflation or deflation, that rate would be approximately equivalent to what is termed, in finance, the risk-free rate of interest. Since entrepreneurs can earn that return on their money simply by buying high-grade bonds, they will not undertake capital projects if they estimate that their return will be lower than the risk-free rate of interest. In terms of our analogy, it makes no sense to plan to travel 70 miles per hour on our trip if the consumers are only willing to turn off the AC (put off current consumption) enough for us to travel 55 miles per hour. For any project that returns less than the riskfree rate of interest, the consumers are indicating that they would, in fact, prefer that the resources necessary be used for current consumption rather than being invested in that project.
Tags: ABCT, Boom and Bust, business cycle, Federal Reserve
